Why would anyone buy shares, with all their swings and the chance of losing money, when government bonds pay a steady return? The answer is that investors expect to be paid extra for taking the risk. That extra is the equity risk premium, and it is one of the most important ideas in finance, even though nobody can measure it precisely.
What the premium is
The equity risk premium is the additional return investors expect from owning shares compared with a risk-free investment, usually short-term government bills or longer-term government bonds. If investors expect shares to return 8% a year and government bonds pay 4%, the expected premium is 4 percentage points.
It is a reward for uncertainty. Company profits can fall, dividends can be cut and share prices can crash. Bonds issued by stable governments, by contrast, are expected to pay back in full. Investors demand compensation for bearing that extra risk.
Historical versus expected
There are two ways to think about the premium. The historical premium looks back at how much shares have actually beaten bonds over long periods. In the US and UK, shares have outperformed government bonds by several percentage points a year over the past century, although the figure depends heavily on the period chosen.
The expected premium looks forward. It is what investors require today, and it cannot be observed directly. Analysts estimate it in different ways, often by comparing the earnings yield on shares, which is earnings divided by price, with the yield on government bonds.
A simple estimate
One rough method takes the earnings yield of a stock market index and subtracts the real or nominal yield on government bonds. If an index trades at 20 times earnings, its earnings yield is 5%. If ten-year government bonds yield 4%, the gap is 1 percentage point. A narrow gap suggests shares offer little extra reward over bonds. A wide gap suggests the opposite.
This is a blunt tool. It ignores growth in future profits and differences in how earnings are measured. But it is widely used as a quick gauge of how expensive shares look relative to bonds.
Why it matters for markets
The premium links bond yields and share prices. When government bond yields rise, the hurdle for shares rises too. Unless profits grow faster, share prices may need to fall to keep the premium attractive. Our guide to real interest rates explains why yields matter so much for valuations.
That is why periods of sharply rising bond yields often hit highly valued shares hardest. When safe bonds pay more, investors are less willing to pay high prices for profits expected far in the future.
What moves it
The premium tends to widen in periods of fear, when investors demand more compensation for risk. In a financial crisis or recession scare, share prices fall and the implied premium rises. In confident markets it tends to narrow, as investors accept less extra reward.
Inflation, interest rate uncertainty and political risk can all affect it. Some analysts have argued that the premium on US shares has become unusually thin in recent years, as share prices rose while bond yields climbed. Others say strong profit growth from large technology companies justifies it.
What it means for traders
The premium is not a timing tool. Shares can stay expensive relative to bonds for years. But it is a useful way to judge how much margin for error the market has. A thin premium means shares are more vulnerable to disappointment, whether from weaker profits or higher yields.
The bottom line
The equity risk premium is the extra return investors demand for holding shares over bonds. It ties share valuations to bond yields and widens when fear rises. Estimating it is imprecise, but watching it helps judge how much risk is being priced into shares. If you want to test how well you understand valuation and risk, take the free Samuel & Co trader assessment.
